MACROECONOMIC

ENVIRONMENT
3. Keynesian Theory
Of Income
Determination

Economic survey 2013-14

Eco survey, 2013-14 : key indicators

Economic survey, 2014-15

Twin Deficits
Country
China
India
Japan
USA

Figures show percentage of GDP (For 2012)

I
St
Consolidated BD
TD
Spvt
49
35
21
20

51
30
22
17

1.0
8.0
10.0
6.0

-2
5
-1
3

52
38
32
23

Twin Deficits
Country

Figures show percentage of GDP (For 2013 or 2014)

I
St
Consolidated BD TD
Spvt

China(2013)
India
Japan(2013)
USA(2013)
UK
Germany
Russia(2013)

48.1
32
22.7
20.4
16.5
19
22

50
30.6
22
18
11
26
24

2.1
7.4
10.0
6.8
6
0.7
-0.1

-1.9
1.4
0.7
2.4
5.5
-7
-1.8

52.1
38
32
24.8
17
26.7
23.9

The Budget
Is there a reason for concern over a budget
deficit?
The fear is that the governments borrowing
makes it difficult for private firms to borrow
and invest & thus slows economic growth.
The budget surplus is the excess of the
governments revenues, TA, over its
expenditures consisting of purchases of goods
and services and TR:
i.e BS = TA G - TR
A negative budget surplus is a budget deficit.

Effects of Government Purchases

on the BS
How do changes in fiscal policy affect the budget? OR Must
an increase in G reduce the BS?
An increase in G reduces the surplus, but also increases
income, and thus tax revenues.
- Possibility that increased tax collections > increase in G.
The change in income due to increased G is equal to
Y0 G G , a fraction of which is collected in taxes
Tax revenues increases by tG G
The change in BS is BS TA G
tG G G
(1 c )(1 t )

G
1 c(1 t )

The change is negative

OR reduces the surplus.

Effect Of Increase In Tax Rate On

The BS
Assuming G to be constant, an increase in
tax rate, t, decreases income. But despite
decrease in income (due to increase in t),
there is increase in the BS.

Full Employment Budget Deficit Vs Cyclical

Budget Deficits
Full employment BD ( or structural BD ): is the BD that
would occur if the economy were at full employment ( or
potential ) output.
Cyclical BD : is the BD that occurs during recessions
when govt expenditures rise and govt receipts fall.

Actual Total BD = Structural BD + cyclical BD

Faster economic growth tends to raise revenues (from
tax) above, and reduce outlays (due to transfer
payments) below, what they otherwise would have been.
That is, it may be difficult to examine the ups and downs
in the actual govt budget deficit and discern whether
those changes reflect the fluctuations of the economy(i.e
BCs), or are due to deliberate changes in fiscal policy.

Full Employment Budget Deficit Vs Cyclical

Budget Deficits
Analysing changes in the full employment BDs is a way
of separating changes in budget totals that are due to
changes in overall economic conditions from those
changes that are the result of deliberate changes in tax
and spending policy.

Eg : If economy is below FE level (implying a recession),

then FE measure of outlays is less than actual outlays;
FE receipts are higher than actual receipts, and thus the
FE-BD would be smaller than the actual deficit.
BD = G + TR tY
BD* = G + TR tY*
i.e BD* - BD = t(Y Y*)

EXERCISE
2(a). In the small country of Eurasia people do salmon fishing, they
produce canoes and also grow corn. In 2003 they produced 5000 canoes
using labour and natural materials only, but sold only 4000, as the
economy entered a recession. The cost of producing each canoe was
$1000, but the ones that sold were priced at $1250. They fished $30
million worth of salmon. They used $3 million of the salmon as fertilizer for
corn. They grew and ate $55 million of corn. What was Eurasias GDP in
2003? Explain your methodology.

Exercise
Given Indirect taxes = Rs 35 lks; YD = Rs
5100 lks; direct taxes = Rs 900 lks.
Calculate NNPmp.

Exercise 1
Using the data given below relating to the components of
the consumer price index of a country, determine the
annual rate of inflation for 2006 as measured by the
change in the consumer price index.
------------------------------------------------------------------------------Item

Index weight

Food
Housing
Transport
Other Goods

20
20
15
15

Price index on 31st Dec, 2005

140
126
152
130

Price index on 31st Dec, 2006

145
135
146
125

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Exercise 2
Consider an economy that consists only of those who
bake bread and those who produce its ingredients.
Suppose that this economys production is as follows: 1
million loaves of bread (sold at $2 each); 1.2 million
pounds of flour (sold at $1 per pound); and 100,000
pounds each of yeast, sugar, and salt (all sold at $1 per
pound). The flour, yeast, sugar, and salt are sold only to
bakers, who use them exclusively for the purpose of
making bread.
a) What is the value of output in this economy (i.e.
nominal GDP)?
b) How much value is added to the flour, yeast, sugar,
and salt when the bakers turn them into bread?

Exercise 3
Kongkong is a small island nation. Its population
total is 400 and it has 100 wage earners who
earn an average of $50 per year. Each wage
earner spends $40 per year buying local goods
and services and $3 per year buying imports.
The island exports a total of $800 worth of
goods. The govt tax rate is 10% and all govt
money is spent on building infrastructure and
supporting schools. There is only on industry (al
mining) on the island and it employs every wage
earner. The industry spends $600 each year on
new mining equipment.
Calculate GDP of the country.

Exercise

Suppose the consumption function is given by C =

100 + 0.8Y while investment is given by I = 50.

a)

What is the equilibrium level of income?

b)

What is the level of saving in equilibrium?

c)

If for some reason, output is at the level of 800, what

will be the level of involuntary inventory accumulation?

d)

If I rises to 100, what will be the effect on the

equilibrium income?

e)

What is the value of the multiplier, , here?

Exercise
Suppose we have an economy described by the
following functions:
C=50+0.8YD; I=70; G=200; TR=100; t=0.20
a)Calculate the equilibrium level of income and multiplier in
this model.

b)Calculate the budget surplus(BS).

c)Suppose t increases to 0.25. What is the new eqn
income? The new multiplier?

d)Calculate the change in BS. Would you expect the

change in BS to be more or less if c=0.9 rather than 0.8.
e)Explain why multiplier is one when t=1.